A beginner’s guide to small caps

1.Size

A small cap is classified as a company with a market capitalization between $300 million and $2 billion.

2.Risk

Small caps are riskier than larger cap stocks as they are smaller companies and may still be in the growth stage.  Larger caps generally have a more mature business and have more resources to weather any economic downturns. As large cap stocks have been operating for a while, they have established clients and are more stable companies.

3.Returns

As large caps are established businesses, they are often less likely to experience the same sort of share price appreciation that small caps do. The potential for small caps to expand and grow provides these companies the opportunity to greatly increase in share price value.

4.Liquidity

Small cap stocks are less liquid compared to large cap stocks. This means that a large buyer or seller of these stocks can impact the stock price. If a small cap stock is unpopular, then it may be hard for the seller to dispose the stock as there may not be a lot of sellers.

5.When to buy

Small caps perform the best in a rising rate environment. This means the economy is recovering and is strong. When the economy is weak, small caps are out of favour as they are seen as risker than the larger cap companies.

6.Suitability

Small caps are suitable for the investor who have a lengthy time horizon to invest and can weather the volatility of these stocks. As these stocks are highly risky, they are suitable for the client who has higher tolerance for risk. Investors looking for regular income from their investment would not find small caps suitable as they also often don’t pay a dividend.

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7.Income or capital

Small cap stocks are better for capital growth and large cap stocks are better for income. As small cap companies are in the growth phase, they tend to reinvest their earnings to expand their businesses so do not pay dividends. Larger cap companies have already completed this growth and have the capacity to pay steady streams of dividends.

8.Publicly available data

There is less publicly available information available for small cap stocks which adds to the risk of investing in these companies. Public information is more readily available for large cap stocks making it easier for investors to analyse the fundamentals of a company. On the flip-side, because there is not of lot of information out there, investors can often obtain small caps at cheap prices because they have flown under the radar of the rest of the market.

Lauren Hua is a private client adviser at Fairmont Equities.

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